Maligayang Araw!

AUDITING AND ASSURANCE

PRINCIPLES

CANOSA, Danica Mae T.

Chapter 12

Fraud and Error

Fraud and
Error
Introduction
 Fraud and Error

PSA 240, “The Auditor’s

Responsibility to Consider Fraud in
an Audit of Financial Statements”
establishes standards and
provides guidance on the auditor’s
responsibilities relating to fraud
and error in the audit of financial
statements.
Characteristics of Fraud
 Characteristics

The distinguishing factor

between fraud and error is
whether the underlying action
that results in the misstatement
of the financial statements is
intentional or unintentional.
 Types of Intentional
Misstatements

1) Misstatements resulting from

fraudulent financial reporting
2) Misstatements resulting from
misappropriation of assets
 Fraudulent
Financial Reporting
Fraudulent Financial Reporting

➔ involves intentional misstatements including

omissions of amounts or disclosures in financial
statements to deceive financial statement users
➔ can be caused by the efforts of management to
manage earnings in order to deceive financial
statement users by influencing their perceptions
as to the entity’s performance and profitability
It may be accomplished by the following:

➔ manipulation, falsification (including forgery), or

alteration of accounting records or supporting
documentation from which the financial
statements are prepared
➔ misrepresentation in, or intentional omission
from, the financial statements of events,
transactions or other significant information
It may be accomplished by the following:

➔ intentional misapplication of accounting

principles relating to amounts, classification,
manner of presentation, or disclosure
It can be committed by management
overriding controls using such techniques as:

➔ recording fictitious journal entries, particularly

close to the end of an accounting period, to
manipulate operating results or achieve other
objectives
➔ inappropriately adjusting assumptions and
changing judgements used to estimate account
balances
It can be committed by management
overriding controls using such techniques as:

➔ omitting, advancing, or delaying recognition in

the financial statements of events and
transactions that have occurred during the
reporting period
Misappropriation
of Assets
Misappropriation of Assets

➔ involves the theft of an entity’s assets and is

often perpetrated by employees in relatively
small and immaterial amounts
➔ involves management who are usually more able
to disguise or conceal misappropriations in ways
that are difficult to detect
It can be accompanied in a variety of way
including:

➔ embezzling receipts
➔ stealing physical assets or intellectual property
 Responsibility for
the Prevention and
Detection of Fraud
Responsibility for the Prevention and
Detection of Fraud
 The primary responsibility for the prevention and
detection of fraud rests with both those charged
with governance of the entity and management.
 This involves a commitment to creating a culture
of honesty and ethical behavior which can be
reinforced by an active oversight by those charged
with governance.
Responsibilities of
the Auditor
Risk Assessment

In planning the audit, the auditor should assess

the risk that fraud and error may cause the financial
statements to contain material misstatements and
should inquire the management as to any fraud or
significant error which has been discovered.
Risk Assessment

Increase the risk of fraud and error include:

 Questions with respect to the integrity or

competence of management
 Unusual pressures within or on an entity
 Unusual transactions
 Problems in obtaining sufficient appropriate audit
evidence
Detection

The likelihood of detecting errors ordinarily is

higher than that of detecting fraud, since fraud is
ordinarily accompanied by acts specifically designed
to conceal its existence.

Whether the auditor has adhered to these

principles and procedures is determined by the
adequacy of the audit procedures undertaken in the
circumstances.
Inherent Limitations of an Audit

An audit is subject to the unavoidable risk that

some material misstatements of the financial
statements will not be detected, even though the
audit is properly planned and performed in
accordance with PSA.

The auditor should plan and perform the audit

with an attitude of professional skepticism.
Procedures When Errors
or Irregularities are
Suspected
 When an auditor detects
factors that increase audit risk at
the financial statement level, he
or she should respond to such
elevated risk by altering the

1. Engagement staffing
2. Extent of staff supervision
3. Degree of professional
skepticism applied, and/or
4. Overall strategy for the
expected conduct and scope of
the engagement
 The extent of such modified
or additional procedures depends
on the auditor’s judgment as to:

a) The types of fraud and error

indicated;
b) The likelihood of their
occurrence; and
c) The likelihood that a particular
type of fraud or error could
have a material effect on the
financial statements.
Examples of Fraud
Risk Factors
Risk Factors Relating
to Misstatement
Resulting to
Fraudulent Financial
Reporting
 A. Incentives / Pressures

1. Threatened financial stability or profitability

brought about by economic, industry, or entity
operating conditions such as

(a) High degree of competition or market saturation

(b) High vulnerability to rapid changes
(c) Significant declines in customer demand and
increasing business failures
 A. Incentives / Pressures

2. Excessive pressure from management to meet

the requirements or expectations of third parties
due to the following:

(a) Profitability or trend level expectations of

investment analysts, institutional investors, significant
creditors, or other external parties
(b) Need to obtain additional debt or equity financing
to stay competitive
 A. Incentives / Pressures

3. Threatened personal financial situation of

management or those charged with governance
relative to the entity’s financial performance due
to

(a) Significant financial interests in the entity

(b) Personal guarantees of debts of the entity
 B. Opportunities

1. Nature of the industry or the entity’s operations

provides opportunities to engage in fraudulent
financial reporting that can arise from

(a) A strong financial presence or ability to dominate a

certain industry sector
(b) Assets, liabilities, revenues or expenses based on
significant estimates
(c) Significant, unusual, or highly complex
transactions
 B. Opportunities

2. Ineffective monitoring of management due to

(a) Domination of management by a single person or

small group without compensating controls
(b) Oversight by those charged with governance over
the financial reporting process and internal control is
not effective
 B. Opportunities

3. Complex and unstable organizational structure

evidenced by

(a) Difficulty in determining the organization or

individuals that have controlling interest in the entity
(b) Overly complex organizational structure
(c) High turnover of senior management, legal
counsel, or those charged with governance
 B. Opportunities

4. Deficiency in internal control components

resulting from

(a) Inadequate monitoring of controls

(b) High turnover rates or employment of accounting,
internal audit or information technology staff that are
not effective
(c) Accounting and information systems that are not
effective
 C. Attitudes and Rationalizations

1. Communication, implementation, support, or

enforcement of the entity’s values or ethical
standards by management, or the
communication of inappropriate values or
ethical standards, that are not effective.
2. Excessive interest by management in
maintaining or increasing the entity’s stock
price or earnings trend.
 C. Attitudes and Rationalizations

3. The practice by management of committing to

analysts, creditors, and other third parties to
achieve aggressive or unrealistic forecasts.
4. Management failing to correct known material
weaknesses in internal control on a timely basis.
5. An interest by management in employing
inappropriate means to minimize reported
earnings for tax-motivated reasons.
Risk Factors Arising
from Misstatement
Resulting to
Misappropriation of
Assets
 A. Incentives / Pressures

1. Personal financial obligations may create

pressure on management or employees with
access to cash or other assets susceptible to theft
to misappropriate those assets.
 A. Incentives / Pressures

2. Adverse relationships may be created by the

following:

(a) Known or anticipated future employee layoffs

(b) Recent or anticipated changes to employee
compensation or benefit plans
(c) promotions, compensation, or other rewards
inconsistent with expectations
 B. Opportunities

1. Certain characteristics or circumstances may

increase the susceptibility of assets to
misappropriation

(a) Large amounts of cash on hand or processed

(b) Inventory items that are small in size, of high
value, or in high demand
(c) Fixed assets which are small in size, marketable, or
lacking observable identification of ownership
 B. Opportunities

2. Inadequate internal control over assets may

increase the susceptibility of misappropriations of
those assets

(a) Inadequate segregation of duties or independent

checks
(b) Inadequate oversight of senior management
expenditures
(c) Inadequate management oversight of employees
responsible for assets
 C. Attitudes and Rationalizations

1. Disregard for internal control over

misappropriation of assets by overriding
existing controls or by failing to correct known
internal control deficiencies.
2. Behavior indicating displeasure or
dissatisfaction with the entity or its treatment of
the employee.
3. Tolerance of petty theft.
Reporting of Fraud
and Error
 Communication to Management and
With Those Charged with Governance

★ the auditor suspects fraud may exist, even

if the potential effect on the financial
statements would be immaterial; or
★ fraud or significant error is actually found
to exist.
 Documentation

★ The significant decisions reached during

the discussion among the engagement
team regarding the susceptibility of the
entity’s financial statements to material
misstatement due to fraud; and
★ The identified and assessed risks of
material misstatement due to fraud at the
financial statement level and at the
assertion level.
 Withdrawal from the Engagement

★ Determine the professional and legal

responsibilities applicable in the
circumstances, including whether there is
a requirement for the auditor to report to
the person or persons who made the audit
appointment or, in some cases, to
regulatory authorities;
 Withdrawal from the Engagement

★ Consider whether it is appropriate to

withdraw from the engagement, where
withdrawal from the engagement is legally
permitted; and
 Withdrawal from the Engagement

★ If the auditor withdraws:

i. Discuss with the appropriate level of
management and those charged with
governance
ii. Determine whether there is a
professional or legal requirement to report to
the person or persons who made the audit
appointment
Short
Quiz
 Short
Qu iz
1. Fraud may be most properly defined as
a. False representation or concealment of a material fact to the
benefit or detriment of an individual or organization.
b. Extortion in which the threat of physical violence is used to
coerce someone to part with something of value.
c. The use of company assets for one’s own personal purposes.
d. Outright theft of company assets without falsification of
records to conceal the act.
 Short
Qu iz
2. Proper segregation of duties reduces the
opportunities in which a person could both
a. Journalize entries and prepare financial statements
b. Record cash receipts and record cash disbursements
c. Establish internal control and authorize transactions
d. Perpetuate errors and irregularities and conceal them
 Short
Qu iz
3. Which of the following ordinarily is designed to
detect possible material peso errors on the financial
statements?
a. Control testing
b. Analytical procedures
c. Computer controls
d. Post-audit working paper review
 Short
Qu iz
4. Fraud may be perpetrated with the intent to benefit a
company. Which of the following is an example of such a
fraud?
a. Acceptance of bribes or kickbacks by a purchasing agent.
b. Claims submitted for services or goods not actually provided
by the company.
c. Sales or assignment of fictitious or misrepresented assets.
d. Diversion by an employee or outsider of a transactions that
would normally generate profits for the company.
 Short
Qu iz
5. The risk of management fraud increases in the
presence of
a. Management incentive systems based on operating income
b. Improved internal control
c. Substantial increases in sales
d. Frequent changes in suppliers
 Answe
rs
1. A
2. D
3. B
4. C
5. A
Thank
you!